Chapter 1 Solutions - 1-1 Star%ng a business during ...

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Unformatted text preview: 1-1 Star%ng a business during an economic downturn has both pros and cons. The biggest nega%ve is the funding from all sources may be difficult to raise. Banks %ghten lending and VCs and angels usually turn to their exis%ng porAolio companies to ensure they stay afloat. Certain products or services may also be in less demand during a recession. Finally, capital providers may worry that people are becoming entrepreneurs out of necessity rather than to take advantage of a good opportunity. On the posi%ve side, the costs of star%ng a venture may be lower and it should be easier and cheaper to hire good talent. Businesses established during a recession should be well posi%oned to grow when the economy turns around. Finally, a long list of well- known and successful companies were started during economic downturns - proof that good ideas and strong management can be successful in any environment. 1-2 Innova&ve entrepreneurship involves the crea&on of new products or services . It has the poten&al to disrupt exis&ng markets and industries and also can create significant value for the entrepreneur. Examples of innova&ve entrepreneurship include FEDEX, Google, and Facebook. Replica&ve entrepreneurship concerns exis&ng products and services. The entrepreneur may deliver these more efficiently or to new markets, but many replica&ve businesses grow slowly, stay small, and are confined to a local area. Replica&ve businesses include dry cleaners, restaurants (although these can also be innova&ve), and harware stores. 1-3 The value of an op-on refers to what an investor would be willing to pay today to acquire the op-on to make a choice in the future. The value of any op-on, including a real op-on, depends on the underlying uncertainty. If there is no uncertainty about the future, an op-on has no value. For example, the real op-on to expand is not valuable if we already know there will never be any reason to expand or that expansion will always be warranted. Usually, there is a cost associated with exercising an op-on. Expansion, for example, can be expensive. If uncertainty is low, it may be that even in good states of the world the benefit of expanding is not sufficient to cover the cost of exercising the op-on, or that the value is only slightly above the exercise cost. In cases where expansion would produce benefits that only slightly exceed the exercise cost, the op-on ot expand is not very valuable. 1-4 The value to the entrepreneur depends on the size of his or her stake in the venture. Strategies may result in a lower value of the overall venture, but a larger payoff to the entrepreneur. Because the entrepreneur is more risk averse than the investor, the entrepreneur is more likely than the investor to select low- risk strategies for developing the ventures, even if doing so reduces the expected return. If the investor is well diversified, the investor may prefer higher- risk strategies that offer the potenCal for higher returns. Other factors that can give rise to differences are if the parCes have different expectaCons about the potenCal for the venture. An entrepreneur who is more opCmisCc than an outside investor may make choices that would not maximize value if the entrepreneur were to base the decision on the investor's expectaCons. 1-5 Both rockets and new ventures proceed in stages, with each stage offering the opportunity for minor redirec9on. The new venture receives an ini9al investment, which is analogous to fuel, and when that cash is spent, further investment is required to move to the next stage. The rate of cash consump9on is some9mes called the "burn rate". There are important differences as well. The rocket must carry sufficient fuel for the en9re journey, while the new venture just needs enough to reach the next stage. Another difference is that a rocket has a clear objec9ve before it is launched and that objec9ve does not change. A new venture by contrast, may change its direc9on several 9mes as the entrepreneur and investors learn more about the market and as uncertainty is resolved. 1-6 NO SPECIFIC ANSWER TO THIS QUESTION 1-7 a) Following the classification in Figure 1.4: Development Stage transitions to Start- up between months 12 and 18, when revenue generation begins. During the Early Growth Stage Net Income and Cash Flow are negative, through between months 24 and 30. During the Rapid Growth Stage Net Income is positive but Cash Flow is negative so external financing is still needed. This transitions to Exit Stage between Months 36 and 42. b) Total cash needed is the sum of the negative cash flows through Month 36, in this case, $5,100. c) The first infusion of $1,500 should get the venture to revenue generation, the second of $3,000 is intended to achieve profitability, and the final cash infusion of $600 will bring the venture to positive cash flow. d) Early stage equity investors for the first $1,500 (possibly angels). Once the venture has revenue, venture capitalists may be interest in providing the $3,000 (especially given the growth potential). The final investment of $600 could be a follow- on VC investment or potentially debt financing depending on the assets avalable as collateral. e) Suggested milestones are proof of concept/prototype, first revenues, profitability, and positive cash flow. Month Sales Profit Free Cash Flow 16000 14000 12000 10000 8000 6000 4000 2000 0 -2000 -4000 6 12 $0 ($200) ($1,000) $0 ($300) ($500) 18 $100 ($500) ($2,000) 24 $500 ($200) ($1,000) 30 $1,000 $100 ($500) 36 $2,500 $300 ($100) 42 $5,000 $700 $300 48 $10,000 $2,000 $1,000 54 $12,000 $2,500 $2,000 60 $15,000 $3,500 $3,000 Sales Profit Free Cash Flow 6 12 18 24 30 36 Month 42 48 54 60 Total Cash Needed ($5,100) 1-8 One of the most common complaints among entrepreneur is that the VCs tend to usurp the en6re venture from the entrepreneur in return for the investments. That being the case, benefits of limi6ng the investments of the VC are big and bold. It directly results in limited loss of ownership stake or none at all and hence more freedom for the entrepreneur in making decisions and realizing the dream of taking the venture in whatever direc6on he wants. Also, the entrepreneur would have more freedom in scou6ng for beCer financing terms as and when the need arises, of course based upon beCer than expected performance of the venture. Since the VC has limited his risk in the venture, the entrepreneur can leverage the performance of the venture to nego6ate and bargain for beCer deals with the same VC. On the other side, when the VC has invested upfront cash needed for the en6re venture, the entrepreneur can devote more 6me and be more focused in the managing the venture and take it to success rather than run from pillar to post every couple of months for financing the venture. When the venture has enough cash in hand , say 6ll harves6ng 6me horizon, it gives the management team of the venture, say the entrepreneur more leeway in managing and in day to opera6ons of the venture. It also gives the entrepreneur a bigger 6me horizon, to plan for and work for, which is needed in the success of the venture. 1-9 While the financial projec0ons are based on assump0ons that are subject to great uncertainty and are virtually certain not to be realized, it is at least as important to understand how uncertainy affects the value of the opportunity as it is to understand the expected performance. Furthermore, by seAng out the assump0ons and projec0ons explicitly, it is easy to track and analyze devia0ons from the forecast and to revise the projec0ons accordingly. Do so enables beDer decision making aEer the ini0al investment. 1-10 In some cases, this is a legi0mate concern. Some0mes windows of opportunity are very short and the 0me and effort available for planning are extremely limited. The entrepreneur needs to understand this tradeoff and to strike a balance between the need for quick ac0on and the value of a more comprehensive and accurate analysis of the opportunity. 1-11 A large historical investment by the entrepreneur indicates that, at the 7me of the investment(s) the entrepreneur believed in the venture enough to commit at least that amount to it. However, if the investment is sunk, the size of the investment does not indicate much about the entrepreneur's current beliefs about the opportunity. The only way to test the entrepreneur's current beliefs is to look at the commitment the entrepreneur is willing to make going forward. If the historical investment is not sunk, then that investment is effec7vely and ongoing commitment. The extent to which the con7nuing investment will become sunk in the future says a lot about the entrepreneur's current beliefs. If the the investment will quickly become sunk, then the entrepreneur clearly believes in the merits of the venture. If the investment will not become sunk, or only become sunk slowly, then it tell us less about the entrepreneur's current beliefs about the venture's prospects. 1-12 In general, the cost of the cer0fica0on is related to the benefit. An investor who recognizes the value of an opportunity, even without cer0fica0on may be able to discount the valua0on by the cost the entrepreneur would have to incur acquire cer0fica0on and find an alterna0ve investor. This investor is effec0vely able to act as both cer0fier and investor. Only when informed investors are compe0ng to find ventures is the entrepreneur likely to benefit by avoiding the costs of cer0fica0on. 1-13 With equity financing, the investor is concerned with the total value of the venture. With debt financing, the investor is solely concerned with the venture's ability to repay his loan's principle and interest. A business plan seeking debt would focus on the collateral available and the venture's ability to generate sufficient cash flows to repay the loan. It should also show a clear commitment to avoid acBons that might increase the value of the firm at the cost of increasing the risk of debt repayment. 1-14 Aqua Agua Inc. is relying on a business model that does not make economic sense (deal killer #3). The assump>on that they can sell a commodity at a higher margin - with no differen>a>on - is a viola>on of basic economic principles. Dialects 'R Us has commiHed deal killer #2, failing to iden>fy clearly a narrow target market. They are assumiing that because the market is so large at 1.3 billion people, that geLng a 0.08% market share will be easy. They need a specific plan to aHract even that small amount of market share. Frigid Fusion, iis relying on a team that lacks the cri>cal exper>se for the venture (deal killer #4). Although all of the founders have gone to good schools and have MBAs, none have the technical exper>se required to manage a "cold fusion" nuclear technology business. ...
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This note was uploaded on 02/19/2012 for the course FIN 124 taught by Professor Jackson during the Spring '05 term at University of Texas at Dallas, Richardson.

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